One of the biggest challenges in capital markets broadly is that, effectively, you’re trying to analyze the actions of billions of people all at once in a multitude of ways. Many basic theories of human action, interests, and goals are implicit in any analysis of any investment or trade, which is the main reason why getting a call right with a stock or a bond is so hard.
The recent scandal at Red Lobster is a good example.
Darden Restaurants (DRI) sold the Red Lobster chain to Golden Gate Capital, a private equity firm, in 2014 for $2.1 billion. Thai Union then bought $575 million worth of Red Lobster at a $2.3 billion valuation—but the purchase was mostly in equity, meaning that Thai Union spent very little actual cash on the purchase.
Thai Union, which is a global seafood producer based in Thailand, then was able to get preferential purchases of its seafood by Red Lobster in a transaction that helped Thai Union offload a surplus of shrimp that also kept the Red Lobster “endless shrimp” promotion ongoing despite the fact that it cost Red Lobster millions of dollars.
It turns out Thai Union may have been pressuring the CEO of Red Lobster at the time to make this loss leader a permanent menu fixture, allowing for a steady income stream to Thai Union from Red Lobster. Then, claiming quality issues, the CEO allegedly coordinated with Thai Union to eliminate other shrimp suppliers and buy shrimp only from Thai Union.
If you’re wondering, this is not legal, and that’s why a bankruptcy filing and lawsuits are appearing. Just how illegal this apparent conflict of interest is remains unclear, but it does seem clear that the company was not being operated by a fiduciary. This is a big deal; CEOs are legally required to act in the best interest of Red Lobster shareholders (even if those shares are private), and the allegation that the CEO did not do so is a charge of illegal behavior.
There are, of course, other aspects of raiding Red Lobster. The private equity company may have destroyed Red Lobster as a viable business through its sale-leaseback—a process of selling the real estate owned by the company and then leasing it back. This effectively increased Red Lobster’s operating expenses, and since Golden Gate Capital kept the proceeds of that sale and then sold Red Lobster to Thai Union (and other investors) after the real estate sale, so you can see how the private equity guys turned Red Lobster into a money-losing zombie company not long for this world.
From this perspective, Thai Union’s purchase looks like vertical integration. In reality, it was simply purchasing a sales channel to offload excess inventory, accepting the loss on the purchase because the value of the excess inventory sales exceeded the value of the sales channel as an ongoing concern.
More is going to unfold in this story, but for the financial analyst the biggest lesson is that a transaction that looks like one thing on the surface (here vertical integration) can actually be something quite different (using the corpse of a once viable business to squeeze as much profit out of other ventures, whether it’s real estate or catching seafood). Many investors did not and they are paying the price today.
Retail investors don’t need to worry—this is the kind of complex corporate transaction you don’t normally see on public markets. Instead, we are seeing Red Lobster’s creditors (who are owed $1 billion) face losses of up to 100%. They are the biggest victims of the Red Lobster saga, and it may have benefitted them to take a close look at what was going on in ownership, in incentives, and in internal corporate decisions, before deciding to extend Red Lobster credit. Maybe they did and saw innocent vertical integration. But they didn’t see the truth—that this was a zombie company ransacked by investors not once, but twice.